It has long been thought that the pillars of good governance—an independent and attentive board, the separation of top leadership roles, properly aligned incentives between owners and managers, and legal protection for creditors and minority shareholders—increase corporate value during economically stable times. But does this principle hold true during a financial crisis?

This study, the first to examine the impact of firm- and country-level governance practices on the performance of European companies during the Great Recession, finds mixed results. Some elements of good governance remained beneficial during the crisis. But others—particularly board vigilance, incentive compensation, and the separation of the CEO and board chair roles—had a decidedly harmful effect. Responses to quickly changing situations were watered down or delayed, for example, because of heavy board oversight or disagreements between the CEO and the chairman. And in a choppy economic environment, the potential rewards of incentive compensation drew some CEOs into overly risky ventures.

Overall, the lesson is clear, if painfully ironic: The checks and balances on managerial discretion that result from reforms in the wake of a financial downturn may be the very mechanisms that prove dangerously restrictive during subsequent crises. As a result, when confronting turbulent times, boards should consider loosening the reins to give their top managers more flexibility and autonomy to respond to unfolding events, the authors find.

The authors combined several databases to create a unique sample of firms from 26 European countries, from 2004 through mid-2009. They included every firm on each country’s major stock index, for a total of 1,197 large and mature public corporations, the primary users of good governance practices. The authors also included country-specific data, culled from several previous studies, on the overall quality of legal institutions, corruption measures, and the extent of credit protection.

In a series of regression analyses, and after controlling for several factors related to CEO and firm characteristics, the authors measured firm performance by examining stock returns before and during the recession. To establish a baseline for the effect of good governance in the midst of steady economic conditions, the authors first analyzed the period of July 2005 through December 2006. They then analyzed the period following the onset of the financial crisis, from July 2007 through March 2009.

The difference was striking, the authors write. Although good governance principles did not have the dramatic, across-the-board positive benefits during the steady period that one might expect, in no way did they harm the performance of Europe’s biggest public companies. However, once the recession hit, evidence of damage caused by some traditional good governance strategies emerged.

In particular, well-meaning boards and well-intentioned governance structures were often found to have gotten in the way of corrective action. For one thing, firms that had a separate CEO and chairman performed much worse during the Great Recession than comparable companies whose CEO also occupied the board chair position. A CEO who is also chairman has much more control over the firm’s strategy. Similarly, the more board committees a company had, the worse it generally fared, suggesting that an overly complex leadership structure can prevent managers from reacting in a timely fashion to fast-moving events.

Contrary to the conventional thinking on good governance, which posits that smaller boards are more effective at monitoring leaders, firms with larger boards performed significantly better during the crisis. In addition, higher levels of board and committee independence, two vaunted pillars of good governance, had little bearing on performance. On balance, the authors write, “firms which provide greater scope for managerial discretion are better off.”

One of the foundations of good governance is the use of high-powered incentives, typically stock options or annual bonuses, as a way to align the interests of senior managers and shareholders. But the authors found that firms using compensation incentives fared much worse during the Great Recession—which they think is likely because executives took excessive risks and tried to maximize their own short-term pay in the face of a rapidly declining economic situation.

All that said, some aspects of good governance did indeed pay off during both the pre-crisis period and the downturn itself. Namely, the better the quality of a country’s legal system, the better that firms in that country performed, the authors found. Similarly, the level of creditors’ rights protection, which had no measurable impact during normal financial times, had a positive influence once the economy began to sink, when such laws clearly instilled investors with enough confidence to continue backing companies.

The authors had expected to find that relational owners, such as families or parent corporations, would be able to prop up their firms during adverse periods. But no such evidence emerged, probably because relational owners are prone to overmonitoring and meddling in senior management’s decision-making process. Like too-vigilant boards, owners with an incentive to interfere could inhibit the managers they appointed to make the big strategic calls.

The authors note that financial downturns often result in regulations requiring more complex and stringent disclosure rules. But this continued strengthening of governance practices could be too much of a good thing when crises actually occur.

For example, the authors point to their finding that stock options and variable payment plans for executives have largely neutral effects in a normal economic climate, but prove damaging in downturns. This is especially worrisome because equity-based pay packages have been found to increase executives’ leveraging of a firm’s capital. The level of firm leverage—or debt against assets—had the largest negative impact on firm performance throughout the Great Recession, the authors found. In tandem, therefore, leverage and high-powered incentives “may prove to be a particularly combustible recipe in adverse financial circumstances,” the authors write.

As financial systems around the world become more intertwined with each passing year, a company’s ability to respond to contagious economic shocks is likely to become more and more important. Accordingly, boards may need to rethink their approach to governance.

“The implication is that corporate governance prescriptions could be better optimized for periods of munificence, where the primary emphasis is upon maximizing shareholder wealth,” the authors write, “and for periods of adversity, where the emphasis may need to shift toward restoring stability and re-establishing corporate resilience.”

Bottom Line:
Some widely lauded elements of the good governance approach actually proved harmful during the Great Recession. Boards should ensure that their top managers have enough leeway and authority to respond quickly to changing circumstances.

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